Chapter 5 Public Spending and Public Choice

1. Chapter 5Public Spending and Public Choice

2. Introduction The U.S. Postal Service (USPS) delivers nearly 40 percent of the world’s mail. Yet, its annual mail volume has declined by more than 20 percent since 2006. Continuation of USPS operations is dependent on the more than $15 billion in loans provided by the federal government. Why does government sponsor the provision of certain items, rather than allowing private firms to supply them? We will explore this question in Chapter 5.

3. Learning Objectives • Explain how market failures, such as externalities, might justify economic functions of government • Distinguish between private and public goods and explain the nature of the free-rider problem • Describe the political functions of government that entail its involvement in the economy

4. Learning Objectives (cont'd) • Analyze how Medicare affects the incentives to consume medical services • Explain why increases in government spending on public education have not been associated with improvements in measures of student performance • Discuss the central elements of the theory of public choice

5. Chapter Outline • What a Price System Can and Cannot Do • Correcting for Externalities • The Other Economic Functions of Government • The Political Functions of Government • Public Spending and Transfer Programs • Collective Decision Making: The Theory of Public Choice

6. Did You Know That ... • A woman searching for scrap metal in the Eastern European nation of Georgia accidentally halted all Internet communication to Armenia? • In shoveling below ground to find unused wires containing copper, the woman sliced through a fiber optic cable. • In her defense, the woman claimed that she was pursuing her own self-interest by looking for scrap metal that could be sold for a profit. • This event is an example of how the market system may cause negative spillovers for third parties.

7. What a Price System Can and Cannot Do • In its most ideal form, a price system allows resources to move from lower-valued to higher-valued uses through voluntary exchange • Economic efficiency arises when all mutually advantageous trades have taken place • There are, however, situations when a price system does not generate the desired results

8. What a Price System Can and Cannot Do (cont'd) • Market Failure • A situation in which the unrestrained market economy leads to too few or too many resources going to a specific economic activity • Prevents economic efficiency and individual freedom • Is addressed by public policy (government)

9. Correcting for Externalities • In a pure market system, economic efficiency occurs when individuals know and must bear the true opportunity cost of their actions • In some cases, the price that someone actually pays for a resource, good, or service is higher or lower than the opportunity cost that all society pays

10. Correcting for Externalities (cont'd) • Market failure: an example • Assume • No government regulation against pollution • A town with clean air • A steel mill opens and emits smoke that causes • More respiratory diseases • Dirtier clothes, houses, cars

11. Correcting for Externalities (cont'd) • Market failure: an example • Market failure occurs • Steel mill does not pay for the clean air • Costs of production have “spilled over” to the residents (third parties) • Lower production cost • More steel is produced than would otherwise be the case

12. Correcting for Externalities (cont'd) • Externalities • Occur when the consequences of an economic activity spill over to affect third parties • Third Parties • Parties who are not directly involved in a given activity or transaction • Property Rights • Rights of an owner to use and exchange property

13. Correcting for Externalities (cont'd) • Externalities are examples of market failures • Pollution is an example of a negative externality • Inoculations generate external benefits

14. Figure 5-1External Costs and Benefits, Panel (a)

15. Figure 5-1External Costs and Benefits, Panel (b)

16. Correcting for Externalities (cont’d) • Resource misallocations of externalities • External costs—market overallocates • External benefits—market underallocates • Government can correct negative externalities • Special taxes (a pollution tax or “effluent fee”) • Regulation

17. Example: Hungary’s Tax on Prepackaged Snacks • The Hungarian government has determined that there are external spillovers on the nation’s health care system from the snack food market. • The government wants to discourage production of sweets, salted snacks, and energy drinks. • Therefore, it has imposed a tax on foods with a high content of sugar, salt, carbohydrates, or caffeine.

18. Correcting for Externalities (cont'd) • How the government can correct positive externalities • Government financing and production • Subsidies • Regulation

19. Policy Example: Stop the Presses for Subsidies! • As newspaper readership has declined over the past decade, some government officials have argued that local newspapers provide positive externalities. • They reason that the information provided by newspapers may save lives. • As a consequence, some state governments provide subsidies for local newspapers.

20. The Other Economic Functions of Government • Providing a legal system • Promoting competition • Providing public goods • Ensuring economy-wide stability

21. The Other Economic Functions of Government (cont'd) • Providing a legal system • Enforcing contracts • Defining and protecting property rights • Establishing legal rules of behavior

22. The Other Economic Functions of Government (cont'd) • Promoting competition • Market failure may occur if markets are not competitive. • Antitrust legislation • Monopoly power

23. The Other Economic Functions of Government (cont'd) • Antitrust Legislation • Laws that restrict the formation of monopolies and regulate certain anticompetitive business practices • Monopoly • A firm that can determine the market price, in the extreme case is the only seller of a good or service

24. The Other Economic Functions of Government (cont'd) • Providing public goods • Goods to which the principle of rival consumption does not apply • These are goods that may be consumed jointly by many individuals at the same time. • In contrast, private goods can be consumed by one individual at a time

25. The Other Economic Functions of Government (cont'd) • What truly distinguishes public goods from all private goods is that the costs incurred in excluding nonpayers from consuming a public good are prohibitive • Individuals in the private sector have little incentive to provide public goods

26. The Other Economic Functions of Government (cont'd) • Characteristics of public goods • Can be used by more and more people at no additional opportunity cost • Difficult to charge for a public good based on consumption—the exclusion principle

27. Example: Private Companies Look to Place Humans in Orbit – and Beyond • Bigelow Aerospace, a private firm, has designed and tested low-cost inflatable space stations in which humans can reside. • Another firm, Moon Express, offers a low-cost method of landing people on the moon. • Other firms are working on the technology to get humans into orbit.

28. The Other Economic Functions of Government (cont'd) • Free-Rider Problem • Arises when some individuals take advantage of the fact that others will take on the burden of paying for public goods • The free-rider problem often emerges in connection with sharing the burden of international defense

29. The Other Economic Functions of Government (cont'd) • Ensuring economy-wide stability • Smooth ups and downs in overall business activity • Full Employment Act 1946 • Full employment • Price stability • Economic growth

30. The Political Functions of Government • Government-Sponsored Goods • Goods deemed socially desirable through the political process • Museums • Government-Inhibited Goods • Goods deemed socially undesirable • Certain psychoactive drugs

31. The Political Functions of Government (cont'd) • Income redistribution: includes progressive income tax system and transfers • Transfer payments • Transfers in kind

32. The Political Functions of Government (cont'd) • Transfer Payments • Money payments made by governments to individuals for which in return no services or goods are rendered • Examples are Social Security old age and disability benefits and unemployment insurance benefits

33. The Political Functions of Government • Transfers in Kind • Payments that are in the form of goods and services • Include food stamps, subsidized public housing, medical care

34. Public Spending and Transfer Programs • Government Outlays • All federal, state and local spending • Examples • Defense, income security, Social Security—at the federal level • Education, health and hospitals, public welfare—at the state level

35. Figure 5-2 Total Government Outlays over Time Sources: Facts and Figures on Government Finance, various issues; Economic Indicators, various issues.

36. Public Spending and Transfer Programs (cont'd) • Publicly subsidized healthcare • Medicare • Began in 1965 • Pays hospital and physicians’ bills for U.S. residents over 65 with public monies • 2.9% of earnings taxed • Second biggest domestic program in existence • Medicaid • Subsidizes people with lower incomes

37. Figure 5-3Federal Government Spending Compared to State and Local Spending Sources: Economic Report of the President, Economic Indicators.

38. Figure 5-4 The Economic Effects of Medicare Subsidies

39. Public Spending and Transfer Programs (cont’d) • To increase the quantity of medical care, the government pays a subsidy • The price per unit paid to medical service providers increases • The price per unit paid by consumers falls • More medical services are consumed

40. Policy Example: The Great Underestimates of Health Care Expenses • In 1965, officials estimated the 1990 cost of Medicare to be $12 billion, but the actual program cost in 1990 was $110 billion. • Similarly, the actual $45 billion cost of Medicaid in 1990 far exceeded the initial estimate of $7 billion. • Why were the initial estimates inaccurate? • Congress expanded the number of people eligible for both programs. • Officials did not take into account the fact that the use of medical services would increase once these subsidies were provided.

41. Public Spending and Transfer Programs (cont’d) • Health Care Subsidies Continue to Grow • The cost of Medicare is now $550 billion per year, and unfunded guarantees of future spending exceed $25 trillion. • In addition, the federal government pays the expenses of Medicaid, a program that provides health care for low-income citizens. • The current cost of Medicaid is more than $400 billion per year.

42. What If . . . the federal government reduces out-of-pocket prices consumers pay for health care services? • If out-of-pocket prices continue to fall, more health care services will be demanded by consumers. • Yet, providers would require higher prices in order to expand the volume of care. • Therefore, higher subsidies would be required, thereby raising the total government outlay.

43. Public Spending and Transfer Programs (cont’d) • Economic Issues of Public Education • State and local governments provide primary, secondary, and post-secondary education at prices well below those that would otherwise prevail in the marketplace • Publicly subsidized, similar to government subsidized healthcare • Education priced below market

44. Public Spending and Transfer Programs (cont’d) • The Incentive Problems of Public Education • Various measures of performance show no increase or decline in performance • Many economists argue failure to improve relies on incentive effects • Higher subsidies may translate to services unrelated to learning

45. Example: A Weak Relationship Between Spending and Schooling Results • Alaska, New Jersey, New York, Vermont, and Washington are the states with the highest levels of per-pupil spending in public schools. • The five lowest per-pupil spending states are Arizona, Idaho, Oklahoma, Tennessee, and Utah. • Yet, the educational outcomes do not differ much between these two groups of states.

46. Collective Decision Making: The Theory of Public Choice • Collective Decision Making • How voters, politicians, and other interested parties act and how these actions influence non-market decisions

47. Collective Decision Making: The Theory of Public Choice (cont'd) • Theory of Public Choice • The study of collective decision making • Assumes that individuals will act within the political process to maximize their individual (not collective) well-being

48. Collective Decision Making: The Theory of Public Choice (cont'd) • Similarities in market and public-sector decision making • Self-interest • Opportunity cost • Competition • Similarity of individuals, but different incentive structures

49. Collective Decision Making: The Theory of Public Choice (cont'd) • Incentive Structure • The system of rewards and punishments individuals face with respect to their actions

50. Collective Decision Making: The Theory of Public Choice (cont'd) • Differences between market and collective decision making • Government goods at zero price • Use of force • Voting versus spending